All About Owner Financing
One unique (and creative!) way to get a deal funded that I absolutely love is through Owner Financing (also called Seller Financing).
In a nutshell, Owner Financing is simply that – instead of the buyer getting a loan to buy the house, the seller himself provides the financing to fund the purchase.
This is done when the buyer has difficulty securing a mortgage or getting approved for a loan (mostly because of strict lending rules etc) – but is seen as “financially able” to buy a house.
Here’s how this works:
The seller and the buyer execute an agreement that provides for an agreed upon interest to be put on top of the property’s asking price, a payment schedule and possible penalties for failure to meet terms.
For example: The house is agreed to be sold and bought for $100,000 with a X% interest, payable in 5 years with a balloon payment at the end of the term.
The idea behind the balloon payment is that the buyer should be able to refinance by that time or pay it off with cash possibly.
After the agreement is finalized, the buyer then send his monthly mortgage payment to the seller, who, not only makes money out of the sale of the property, but also profits from the interest rate.
Owner Financing is quite uncommon because most sellers think it’s risky. Moreover, most sellers usually need the proceeds of the sale in order to buy their next home.
What most sellers don’t know, however, is that the loan can be sold to another investor – in which case, the buyer simply makes his monthly payments to the new owner of the loan. It is common practice in these instances for the initial loan terms to remain unchanged.
While, Owner Financing may seem a bit complicated, more and more sellers are beginning to get sold to this idea especially if they’re quite motivated to get their houses sold quickly and this is actually one of my favorite ways to sell houses as an investor because it is generates both large sums of cash with the down payment and nice residual cash flow without all of the headaches of a rental property. Sort of like the best of both worlds :-)
Of course this also benefits buyers, especially those who can’t get (or don’t want to get) traditional funding.
Knowing the basic mechanics of Owner Financing can surely be a great addition to any investor’s toolbox and in order to help you out, I’m going to do something I’ve never done, which is give you a sneak peek into one my private members training videos from the F7XFactor.com.
The F7XFactor.com is a Real Estate Training site with over 100+ Training Videos that covers, in depth, the 7 Fundamentals that it takes to be successful in Real Estate. We also have tons of Forms, Interviews, Live Event Replays and a whole lot more, so be sure to check it out, www.F7XFactor.com.
Anyways, I think you’ll really enjoy this video if you’re interested in Seller/Owner Financing, and if you do, please post a comment below let me know.
All the best,
All right, everybody. We are going to talk about a strategy that I love. I absolutely love this strategy of owner financing. There are some things that you need to be aware of. There’s definitely some strategy items that we need to talk about and decisions that you have to make on whether or not it is wise to use owner financing with your real estate investing business with the model of business that you are putting together.
Let’s first talk about when to owner finance. When to owner finance and when not to owner finance. I’m going to start this module the way I do a lot of modules. I’ll talk to you a little bit about my experience, about my path and how I learned about owner financing.
The first experience that I had actually doing owner financing was with a rental property that had been leased out for a very long time. I had leased it out for probably four/five years, probably four/five years and I think it was five years to the same tenant. A pretty good tenant, pretty good tenant, paid her rent on time most of the time, definitely not all the time. She definitely racked up some late fees but she always paid her rent and took pretty good care of the house. After five years, a house just needs some work. It needs some painting. It needs a little roof work maybe or maybe some carpets depending on the tenant. I can’t remember all the repairs that were needed here but it wasn’t a lot. It was a standard kind of rehab thing.
The thing that happened was I went to go meet with my painters to do the work. My painter said, “I really like this house. We’re trying to buy a house. Could I possibly buy this house from you?” I thought about that question and I was like, “Well,” I made an assumption that he couldn’t get a loan but I asked him. I’m like, “Are you sure you can get a loan on this?” He’s like, “No way. I can’t get a loan. I want to see if you’ll sell it to me directly, meaning owner finance.” I was like, “Let me think about that.”
I’d read about owner finance and knew a little bit about it but had never really done a deal myself. I went and did some research. It turns like, I like that idea. I like the idea of owner financing on this particular property. Here was why it worked out so well on this particular property. One, it was a rental property that I had owned for over a year. This is pretty critical when deciding whether or not to owner finance. Whenever you owner finance a property that you’ve owned less than a year, you will pay more in taxes. You will pay short-term capital gains versus long-term capital gains. That’s the first thing. I’d owned this property for five years, so that was fine.
Two, didn’t have to do any repairs. He was going to do all the repairs. That was something that I’d communicated with him and negotiated. It’s like, “Well, you’re a painter so I’m not going to do any repairs. You know what needs to be done.” He said, “That’s okay. I don’t have a problem with that.” I said, “Okay great.”
Another reason that I liked the idea of owner financing this property was because it was in long-term financing. It was in a long-term financing. I was able to do a wrap mortgage which we’ll talk about in a second a little bit more in-depth. I had long-term financing with that property. It was in an okay neighborhood. This is somewhat important. It was in an okay neighborhood, primarily a rental property type of neighborhood. I didn’t foresee a huge escalation in values from this property because when you owner finance, let’s say the house doubles in value in the next couple of years, then that person who owns the property, whoever you’re going to be providing that mortgage to, they technically own the property in lieu of your lien of course.
If say you sold the house to them for $100,000 and a couple of years later, they could turn around and sell it for two or 300,000, guess what? They can do that. They would realize that profit of everything over what they owe you, the 100,000 minus whatever principal they’ve paid off. That was a risk that I was willing to take. That’s a decision that has to be made every time you’re going to sell owner financing is if you are okay with giving up that appreciation of that property over time. Those are the big decisions that you have to make.
Also, a couple of other things is, a couple of the benefits is like repairs is a big one. You’re no longer responsible for repairs. That owner is responsible for 100% of all the repairs. Two, you’re not collecting rent anymore. It is a mortgage. Whenever someone puts a healthy down payment, when someone puts a healthy down payment then your likelihood of collecting payments becomes much, much, much safer I would say or more consistent than a rental property whenever someone actually owns the property.
In regards to down payment, our policy is like generally 10%. It’s a minimum of 10% down is what we require. This particular buyer could not put 10% down. I was closer to 5% but he was going to be doing the repairs and I know this guy. I’ve known for a long time. He’s worked with me for many, many years. There were some factors, some minimal factors there that I threw into the equation. If this is someone who you’ve never met before, they saw your sign or a listing, I would absolutely require at least 10% down minimum, 10% down minimum.
I will also mention that I’m not a huge fan of just financing a property to someone I’ve never met before. The ideal scenario, although I have done that, the ideal scenario that I like to use owner financing with is with a tenant who’s leased the home for at least a year and they’ve consistently paid their rent on time and taken care of the property. It’s that first year, it’s an interview process for me to make sure that’s someone I want to do business with for the long-term. Then two, it’s better for them as well in terms of they get to be and live there for a year, make sure that it’s a house that they want to spend what is perceivably the rest of their life for a very long time in that home. Make sure it works out for them and works out for you. That is the ideal scenario for me. Like I said, I’ve done it both ways.
Then the next question is if you’re getting 10% down, I want to make sure you understand that not all of that 10% is going towards their principal. $3,000 is on, I’m using a $100,000 home property example. $3,000-ish will go towards closing cost and insurance. Roughly $3,000, probably a little bit more, but 3,000 to $4,000 is just going to go to cover the attorney, doc preparation, title commitment and just miscellaneous closing fees. Then you’re going to want to make sure that you collect one year of insurance upfront right at closing so you don’t have to worry about that.
After that, there’s going to be what? Six to $7,000 worth that will go towards reducing their principal. Then what you’re going to need to decide before you can even start the paperwork and fill out the contract, in Texas, I know this is different in other places but you fill out a standard sales contract. In Texas, it’s a TREC sales contract but there is an owner finance addendum that outlines the financing terms, the financing terms of the owner finance.
One of the critical pieces is how long are you going to finance this property for? How long are you going to finance it for? Are you going to finance it for them in full until it’s completely paid off with a 15-year, maybe 20, 25 or even a 30-year amortization? Are you going to carry the loan that long? Or are you going to have a balloon payment? Meaning you’ll finance the property say for five years with a 9% interest rate and you can amortize it at 15, 20 or 30 years which is the rate that they’re paying down the principal but the loan is going to be due in full at the end of those five years. It’s called a balloon payment.
At the end of five years, they’re either going to have to pay you all in full, the full balance or they are going to have to refinance the property with another lender or with a bank before that period of time or restructure with you. You can have some type of clause that you can renegotiate, renew after five years just depending. You want to stay in a position of power if you will and give yourself, “We’ll probably figure it out after five years,” if that’s what your plans are when you go into this deal, because five years is a long-term. It doesn’t have to be a five-year balloon. It could be a one year, a two year, a three year, somewhere between the three to five years is the most typical. You can do this really any way that you like. Those are the two big things to decide on, or one of the big things to decide on time is if you’re going to fully amortize it or if it’s going to have a balloon payment.
Then the other major factor that you need to decide upon is your interest rate, is your interest rate. We will typically charge interest in the 9% to 10% range depending on the price of the property. The lower the property value in price, we charge a higher interest. The higher the price of the property then we will have to lower our interest because if it gets up to that high, it usually prices the potential buyer out of the home if it’s a two or $300,000 home with a 10% interest rate.
There are some usury laws. We can’t go over other certain percentage. We’ve just found keeping in that 8 to 10 range, and like I said, we’re usually in the 9 somewhere, 8.9 to 9.9 is where we’ve been able to agree to terms without losing a buyer and creating what I believe is a win-win situation. I like that higher interest rate as well because it allows him to get into the property, often to buy the property but it also gives them motivation to get refinanced out of the property. Every month when they write that check, they can say to themselves, “Hmm, we could probably get 3%, 4%, 5% interest on that,” because that’s where interest rates are right now, “Or we’re going to pay 9%.” It gives them motivation incentive to work on their credit and get refinanced so that they can get a low interest rate, you can get paid off in full.
We’ve owner financed homes up to $200,000. We’re working on right now that’s going to be owner financed for 200,000. That one’s going to be, I think at about 8.5% interest is where we came in on that. It works for us, works for them. We are typically in 5 to 7, 7.5% interest on our properties on our mortgage. We like to get two if not 3% higher interest that we’re collecting so that we’re making really good cash flow. That’s why we like owner financing because it is cash flow play. It is a cash flow play and it can be a beautiful thing let’s say for example, if we’re going to wrap a mortgage.
If you have a property that you own outright with cash, owner financing is pretty cut and dry. It’s pretty simple with the note and deed of trust and that type of stuff. There’s not a lot of complexities to get it done. Just make sure as always to use an attorney when you are drawing up your owner finance documents. Always use an attorney. I want to encourage you to always use an attorney.
Then the other thing though is if you have a mortgage on your property, say it is like a Fannie Mae, Bank of America, Green Tree, some of these big mortgage companies, with them, we do what is called a wrap mortgage, a wrap mortgage. Meaning our loan stays in place with that bank. I still owe that bank whatever I owe that bank and I continue to make my payments to that bank. Another mortgage is created and it essentially wraps up mortgage and that is with the new buyers. We’re having mortgage that they will be paying me every month or my company every month on that mortgage and it’s called a wrap mortgage.
There is legalities with this type of structure. There is a clause in most mortgages. It’s called a due-on-sale clause. One of the things that they may exercise the option, it doesn’t say, it’s a mandatory thing they’ll do, is that they may exercise the option to call the loan due if a wrap mortgage is being done. That is one thing to consider. I am aware of that. I’m okay with it because I’ve done enough research on this. I’ve talked to people who’ve been doing this for 20 plus years and never had a loan called due.
From what I’ve been told and what my research has led me to is that the only time that mortgage companies call loans due is when mortgages aren’t getting paid. It’s going to enter in to a wrap structure like that means you’re paying your mortgage on time because you will get your loan called due. Then you’re going to put your buyer in a very tricky, difficult situation that could be very, very messy for them.
With wrap mortgages, do your own due diligence, speak to an attorney. Make sure that you’re working with a real estate specific attorney of course. I’ve found an attorney who specializes in wrap financing. That’s been very helpful. He’s been doing this type of paperwork for a very, very long time so he’s very familiar with it. I felt much more comfortable and confident doing it as well.
That being said, with the wrap mortgage, you have your insurance on your property but the new buyer is going to need to get their own insurance to make sure that they’re covered for the property. They will have their own insurance. They will be the owner on record in terms of the taxes. They have a mortgage with you which means that you don’t need to keep your insurance on the property anymore so that’s savings as well and your new buyer is responsible for taxes. They’re responsible for paying all the taxes of course as well as the insurance. Those are a couple of other benefits that you get with selling owner financing which is great, because there’s a couple of things that you don’t have to pay anymore, things that you don’t have to do, of course you’re doing to make sure and verify that insurance is being paid and taxes are being paid and things like that.
I already mentioned that a year in advance, your insurance has been paid off and that’s great. You don’t have to worry about that for a year. Taxes, they’re going to go to an escrow account. There’s going to be, if your taxes have been escrowed, there’s going to be an escrow with your bank and for depending on the time of the year, your buyer is going to get credit for those taxes but it doesn’t necessarily mean those taxes are going to get paid. This is something that needs to, your carpenter to check every year that the taxes are being paid.
The way that I’ve done this in my business to simplify it is I’ve hired a company specifically specializes in collecting these mortgage payments. This company specializes in collecting owner financed debts. They collect payment every month from the buyer but they also collect a payment for insurance and taxes. I require my owner finance buyer to pay for not only the principal and interest every month but taxes and insurance as well, every month that’s escrowed. This company pays insurance and pays on the taxes. I can sleep good at night. I don’t have to worry about babysitting and checking on whether or not taxes and insurance have been paid. I get a monthly email statement. That’s it.
When you compare this to rental properties, I think you’ll find owner financing is the ultimate way to get cash flow passively. There’s a huge difference between someone who owns a property and paying payments versus a general property and rental payment. The payment consistency being on time with a tenant and things like that is much more consistent with someone who owns a property who’s put a substantial amount of money there will take care of that property.
The tenant, you get calls for repairs. It’s much easier to break lease than someone to just walk away from a property that they’ve purchased. If they do walk away from it. That’s actually one of the positive sides of owner financing. The foreclosure process is of course an option. In Texas, it happens to be fairly simple and you can do it fairly quickly. I know … Financing is a great, great, great cash strategy, just get passive cash to live on and for a long period of time. I love it.
I need to talk about that and some of the downsides. Whenever you sell a owner financed, let’s say that you’re all in a deal for $70,000. You’ve sold it for $100,000 and so you’re financing like $30,000, so you haven’t paid actual cash, but you’re going to show that gain even though you haven’t actually received all that cash, it’s going to be a lot. I know it sucks. It is what it is. [NOTE: Contact your CPA for owner financing tax laws and strategies in your state and based on your personal situation]
Here is my suggestion, everyone’s financial situation is different. Whenever you do a deal or sell that property and you get paid the remainder of that down payment that for example $10,000 dollars, I would have you to consider to place those monies aside in a savings accounts or whatever but have that to go towards some of the payments that you’re going to take on your taxes if you’re expecting to pay taxes. That’s the equivalent to renting the property out for years, you’re going to lose being able to depreciate your properties and you’re probably not to excited to hear that. I can’t lie about that.
With the long-term, it’s just pure cash flow. It’s just pure cash flow. That’s the general overview of owner financing. The good, bad and the ugly. Now all that’s left to do is go out and take action.
All the best